Tax law will mean using your wits in saving for youngsters' college

While Americans try to figure out if the new tax law will leave more or less money in their pockets, there's one group that is almost certain to find life under tax reform more difficult: parents of children planning to attend college. On a number of fronts, the tax bill passed by the House and Senate last month makes saving for college more costly, especially if that saving was being subsidized by Uncle Sam. There are still several good tax-advantaged ways to save for college, but they will require more- active management and more creativity than these old standards:

Clifford trusts, in which parents held assets in a child's name for 10 years and had earnings from those assets taxed at the child's rate, have been eliminated.

Uniform Gift to Minors Act (UGMA) accounts won't work as well, because any earnings in excess of $1,000 from gifts, loans, or accounts in a child's name will be taxed at the parents' rate until the child turns 14.

Parents will no longer be able to deduct the interest from money they borrow to pay for college bills, unless they use home equity loans for that purpose.

As if these changes in the income-shifting rules weren't enough, the colleges may be facing some tax reform troubles of their own. Lower tax rates and the elimination of deductible charitable contributions for non-itemizers could make college fund-raising efforts more difficult. Fewer donations may mean higher tuition, which parents would find more difficult to pay because of the new tax rules.

For most parents, the biggest change will be the taxation of unearned income in a child's name -- that is, income from stocks, savings accounts, or the appreciation of property -- at the parents' rate.

This has already been dubbed the ``kiddie tax,'' and it affects all income, whether received directly, attributed through a trust, or built up in a UGMA account. It does not matter if the property was transferred to the child several years ago or this year, or will be some time in the future.

The only thing not affected, it seems, is money the children earn themselves, such as from a paper route, baby sitting, or lawn mowing. That will continue to be taxed at the child's rate.

For several years, Clifford trusts have been one of the most popular tax-advantaged ways to save for college. Now, any property in trusts created on or after March 2, 1986, that could possibly revert to the grantor or the grantor's spouse will be treated as if it is still owned by that grantor -- and the income will be taxed accordingly.

Clifford trusts set up on or before March 1 are still legal property transfers. Since the income from those trusts is taxed at the parents' rate, however, the main purpose of the trust, which is to have income taxed at the child's lower rate, is eliminated.

The loss of Clifford trusts will not prevent many people from sending their children to college, says David Rhine, a tax partner at Seidman & Seidman, an accounting firm.

``These have been a time-honored way of saving taxes,'' he says. ``But they were often limited to people who could afford the services of an attorney to set them up and an accountant to maintain them every year.''

The point is, he explains, that parents who set up Clifford trusts could often pay college costs anyway: Saving taxes was the primary consideration.

The changes in the UGMA accounts, however, will affect many more people. Many young parents, for example, funnel cash gifts for a new baby directly into special college accounts, where that money is taxed at the baby's rate, which usually means no tax at all.

The loss of this tax break does not mean a taxpayer should stop shifting assets to the children, Mr. Rhine says. Assets in a child's name can still earn up to $1,000 and be taxed at the lower rate. While additional earnings will be taxed at a higher rate, the tax goes down to the child's level after age 14.

``Keep putting money in there so there'll be an economic base'' when the child turns 14, Rhine says. ``It's like bunting a runner over to third to get him in scoring position.''

If you want to save taxes on the account before the child turns 14, you can fill it with tax-deferred instruments like savings bonds, municipal bonds, or muni-bond mutual funds. Even in your own account, tax-exempt securities are particularly attractive now. Yields on 30-year munis have been running at more than 7 percent. Zero coupon municipals give you a tax break and ensure a specified amount of money when you need it. But stay away from zeros with early ``call'' provisions that allow the issuer to redeem them before maturity.

After the 14th birthday, you can transfer all or part of the assets into high-yielding -- but safe -- investments, like high-grade corporate bonds or one-year Treasury bonds.

The tax bill also allows you to borrow against home equity to pay for education expenses and deduct the interest. This is one of the few areas where you can borrow up to appraised value, not just the purchase price plus improvements, so it's worth examining.

``The tax law will mean more creativity and more stick-to-itiveness,'' Rhine says. ``You'll have to work harder.''